Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory for companies for tax purposes. They are also used by managers to assess the performance of the business.
Element | Description | Implications | Examples | Applications |
---|---|---|---|---|
Balance Sheet | A financial statement that provides a snapshot of a company’s financial position at a specific point in time. | – Shows assets, liabilities, and equity. – Helps assess solvency and liquidity. | Year-end balance sheet of a corporation. | Assessing the financial health and stability of a company. |
Income Statement | Also known as the Profit and Loss (P&L) statement, it summarizes a company’s revenues, expenses, and profits. | – Reveals the profitability of a business. – Useful for evaluating performance over a specific period. | Quarterly income statement of a retailer. | Analyzing revenue, expenses, and profit trends. |
Cash Flow Statement | This statement shows how changes in balance sheet and income accounts affect cash and cash equivalents. | – Highlights a company’s ability to generate cash. – Vital for assessing liquidity and cash management. | Monthly cash flow statement of a startup. | Managing cash flow and predicting cash needs. |
Statement of Retained Earnings | Tracks changes in retained earnings over a specific period, accounting for dividends and net income. | – Helps shareholders understand how profits are retained or distributed. – Links income statement to balance sheet. | Quarterly statement of retained earnings. | Demonstrating changes in equity to shareholders. |
Notes to Financial Statements | Supplementary information providing details and context about the items reported in the main financial statements. | – Enhances transparency and clarifies accounting policies. – Discloses contingent liabilities and significant events. | Notes explaining accounting methods used. | Providing additional context and details to financial data. |
Financial Statements Builder
Introduction To The Main Financial Statements
The main financial statements are the Balance Sheet, Income Statement, and Cash Flow Statement.
Together those three documents make up what is usually referred as “financial statements.”
Each of these statements has a different purpose and together they give us specific information in regard to: “Return, Risk, and Cash”.
First, if you look at the income statement, there is no way you would make any assessment about the risk of the organization at that particular point in time or the cash produced in a certain period.
Instead, the Income Statement (or Profit & Loss) will show you the return generated by the business.
Second, if you want to understand how an organization acquired the resources to operate the business, you have to look at the Balance Sheet.
How does the balance sheet assess the risk of an organization?
Simple, there are two ways a company can acquire resources:
either through Equity or Debt.
As you can imagine, too much debt can be dangerous. What would occur if you run a business and suddenly your creditors ask for the money you owe them?
You would go bankrupt. Instead, when debt in proportion to the equity is dismal, this makes your organization creditworthy and safer.
Third, it happened many times in the financial world history to see profitable companies bankrupt due to poor cash management.
The cash flow statement helps you to answer questions such as: How much cash did we make? Where did the cash come from?
In fact, an organization can find cash through three main activities: Operating, Investing, and Financing.
Income Statement (P&L): Show me The Bottom Line
The main purpose of the income statement is to show the return of the business in a certain period: Quarterly, Biannually, or Yearly.
The income statement is built around the bottom line, the “net profit”. Do not be surprised to notice your eyes unexplainably falling on the net income.
This distracts you from other metrics on the Income Statement that are as important as the Net Income.
Balance Sheet: The Power Of The Now
The main purpose of the Balance Sheet is to show the risk of the business in the particular moment you are looking at it.
In Fact, if you look at the balance sheet on January 1st it won’t be the same on January 2nd.
Of course, this is true for the P&L and CFS (Cash Flow Statement) as well, but the balance sheet is an instant snapshot of the business more than a collage of pictures taken in different moments, like the Income Statement.
Cash Flow Statement (CFS): Cash Is King
The main purpose of the cash flow statement is to show the cash generated by an organization in a certain period: Quarterly, Biannually, or Yearly.
It doesn’t matter how much profits a business is making, one way to know whether the business will survive in the next future is to look at the cash.
Generating cash is no easy task and the organizations who are able to keep their profits stable and generate enough cash to sustain their operations and invest for future growth are the ones who thrive.
Real Life Analogy
Let me use a real-life analogy here. If you are a photographer in order for you to do your job, you must have a professional camera.
In addition, you can take instant pictures or build a collage of pictures you have taken in the last three months, and remember the camera will work as soon as the battery will be charged.
Indeed, you can compare the single picture or “instant picture”, on your balance sheet, while the “collage” pictures taken in the last three months, are on your income statement.
Furthermore, you want to see what’s the level of charge of the battery and how long the camera will operate. The battery life can be compared to your cash flow statement.
Indeed, a lack of cash for a business is almost like a lack of oxygen for an individual.
According to your needs, you can look separately at each statement.
However, if you want the whole picture of the business you must look at all of them concurrently.
Key Highlights
- Financial Statements Overview: Financial statements are essential tools used by businesses, investors, analysts, and other stakeholders to gain insights into a company’s financial performance, health, and prospects. The three main financial statements are the Balance Sheet, Income Statement (also known as Profit & Loss), and Cash Flow Statement. Together, these statements offer a comprehensive view of a company’s financial activities, enabling stakeholders to make informed decisions.
- Income Statement (Profit & Loss):
- Revenues and Costs: The income statement provides a summary of a company’s revenues and costs over a specific period, usually a quarter or a year. Revenues encompass all the money the company earns from its operations, such as sales of products or services.
- Profit or Loss: By deducting costs, including production, operating expenses, and taxes, from revenues, the income statement calculates the company’s net income. A positive net income indicates a profit, while a negative net income indicates a loss.
- Return Perspective: The income statement’s primary purpose is to show how effectively a company is generating returns on its operations. It provides insights into the company’s ability to manage costs and generate profits.
- Balance Sheet:
- Financial Position: The balance sheet offers a snapshot of a company’s financial position at a specific moment in time. It presents the company’s assets, liabilities, and equity, following the accounting equation: assets = liabilities + equity.
- Assets and Sources: The balance sheet reveals how a company’s assets are financed—either through debt (liabilities) or equity (ownership). It helps assess the company’s risk profile and creditworthiness.
- Risk Assessment: While the income statement focuses on profitability, the balance sheet evaluates the company’s risk exposure. A well-balanced structure between debt and equity indicates a healthier financial position.
- Cash Flow Statement:
- Cash Movements: The cash flow statement tracks the inflows and outflows of cash resulting from three main activities: operating, investing, and financing. It provides insights into how cash is generated, spent, and managed.
- Liquidity Assessment: The cash flow statement is crucial for assessing a company’s liquidity—its ability to meet short-term obligations and cover operational needs. A positive cash flow from operating activities indicates the company is generating sufficient cash to support its core operations.
- Cash vs. Profits: A business can be profitable on paper (according to the income statement) but face liquidity issues if cash outflows exceed inflows. The cash flow statement helps identify such scenarios and ensures the business can meet its financial obligations.
- Importance of Understanding All Statements:
- Holistic Insight: Each financial statement offers a unique perspective on a company’s financial performance and position. To truly understand a company’s overall health and prospects, stakeholders need to analyze all three statements together.
- Analogous to Photography: The analogy of photography helps illustrate this concept. The balance sheet provides an instant snapshot of the financial position, while the income statement creates a collage of financial performance over time. The cash flow statement, akin to a camera’s battery life, assesses the availability of essential resources.
- Informed Decision-Making: By analyzing all financial statements together, stakeholders can make well-informed decisions about investments, lending, operational strategies, and risk management.
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